7 Lessons about Banking from 200 Years of History

The scene on Wall Street during the Panic of 1907. Source: Wikimedia Commons

The history of finance is dominated by the fact that banks are innately unstable. Even the most conservative lender is only one severe credit cycle away from failure.

It's for this reason that individual investors should tread carefully in this space. And it's also for this reason that if you want to invest in banks successfully, nothing is more important than knowing a little history.

To save you some time, I compiled the following seven lessons picked up in my research and reading about the ebbs and flows of the bank industry over the past 200-plus years.

1. Hundreds of banks will fail every 15 or so yearsIn the nearly 215 years since the turn of the eighteenth century, the United States has experienced 14 major bank panics. That equates to one every decade and a half. And each time this happens, legions of institutions fail due to imprudent lending in happier times.

Most recently, a total of 503 banks have closed since the onset of the financial crisis, including 14 seized by the Federal Deposit Insurance Corporation in the last eight months. But while that may sound like a lot, it most certainly understates the breadth of the crisis, as hundreds more would have failed if they hadn't been rescued by the federal government or acquired by better capitalized competitors.

This is why you should always have the next crisis in mind when picking a bank stock. "No one has a right to not assume that the business cycle will turn," JPMorgan Chase CEO Jamie Dimon drilled into his staff before the last crisis. "Every five years or so, you have got to assume that something bad will happen."

2. The biggest risks are unforeseeableIt's nice to think that a diligent investor could scrutinize a bank's financial statements and determine whether it's taking on too much risk. But even with the benefit of hindsight, this typically isn't possible.

The last crisis serves as a case in point, as the biggest risks to banks weren't included as a line item on the balance sheet; they existed instead in off-balance sheet trusts and contractual obligations to repurchase previously issued securities or mortgages if the underwriting standards were later found to be lacking.

While it doesn't bear directly on the bank industry, the following exchange between my colleague Morgan Housel and the former head of AIG, Hank Greenberg, illustrates this point:

Morgan Housel: Let's say 2006-07, were you personally aware of the risk-taking that was going on inside of AIG? I guess what I'm trying to figure out is, if someone owned AIG stock in 2007 could they, even with hindsight, go back and see, "Oh, look at all this risk that was being taken?"

Hank Greenberg: No, I don't think so. I was a major shareholder of AIG, the largest individual shareholder. I lost about 90% of my net worth.

Whenever you think you've identified all of the risks facing a financial firm, I encourage you to consider author Carl Richards' observation: "Risk is what's left over after you think you've thought of everything else."

3. Current credit metrics should be largely ignoredIf you ever come across an analysis that promotes a bank stock because its current credit metrics are either improving or better than the industry average, do yourself a favor and stop reading it immediately, because there's a good chance the person doesn't know what he's talking about.

As late as July 2007, the CEO of Wachovia, the nation's fourth largest bank by assets at the time, took a moment on the company's second-quarter conference call to praise his bank's risk management:

Net charge-offs continue to be a very low 14 basis points. [Nonperforming assets] increased for us slightly in this quarter; that was primarily in mortgage. But if you compare our mortgage company to almost any other in the industry, our NPAs are outstanding, and our NPAs at a company level would have to be considered outstanding in comparison to our peer group.

Lastly, we are very comfortable with where we sit today in a conservative position in virtually all asset classes.

One year later, Wachovia's losses from underwriting rendered it insolvent, forcing the government to broker a sale of the bank to Wells Fargo. As Warren Buffett has been known to say, "It's only when the tide goes out that you learn who's been swimming naked."

4. The most important thing is a long history of prudent risk managementFinancial professionals like to say that past performance doesn't guarantee future results. But when it comes to bank stocks, I'd urge you to turn this cliché on its head. Indeed, past performance, and particularly as it relates to risk management, is the most important thing to consider before investing in a bank.

My favorite example of this is Citigroup. Its unparalleled knack for landing in the middle of banking crises dates back to the Panic of 1907, when trading by its securities affiliate fueled the panic itself, the founding of the Federal Reserve, and the subsequent passage of the Glass-Steagall act which forbade the commingling of commercial and investment banks until 1999.

Over the next 100 years, Citigroup rarely missed an opportunity to disparage its own reputation. In the early 1920s, sugar loans to Cuba "threatened to wipe out the total capital of the bank." Later that decade, its securities affiliate was caught unloading toxic securities onto the bank's unwitting depositors. In the early 1930s, it underwrote more than $100 million in loans and bonds for the Swedish "match king," Ivar Kreuger, who turned out to be running a Ponzi scheme. And the examples go on and on.

We never thought of Citigroup as a model of caution. It had been at the center of the Latin American debt crisis of the 1980s. The New York Fed had cracked down on it for shenanigans related to the Enron scandal shortly before I arrived, and we hit it with the subprime lending fine that pleased Paul Volcker shortly after I arrived. In 2005, after Citi was forced to shut down its private banking operations in Japan because of illegal activity, we banned the company from major acquisitions until it fixed its internal controls and other overseas governance issues. The British banker Deryck Maughan, whom I knew from his days running Salomon Brothers in Japan, came to see me after he was forced out of his job as chairman of Citigroup's international operations. His message was that Citi was out of control.

Meanwhile, here's how Citigroup's investors have fared since the end of 2006:

5. Be wary of banks that obsess over growthBanking seems complicated, but it's not. "Banking is a bit like running a small retail store," says Jamie Dimon. "You gotta work out what kind of stuff your customers want. Then you gotta get the stock in, and sell it as quickly as you can, making a profit."

But unlike a universal bank like JPMorgan Chase, a typical lender sells only one thing: money. Borrowers need it to buy houses and open or expand businesses, and banks sell it to them at a price (i.e., interest rate) reflecting the likelihood it'll be repaid.

One way a bank can grow quickly, in other words, is to simply loosen its credit standards and sell more money, as you'd be hard-pressed to find someone who won't accept a loan if the price is right. And it's for this reason, that a banker's best quality is the ability to say "no."

The conservative banker is an impressive specimen, diffusing the healthy glow which comes of moderation in eating, living, and thinking. He sits in state and spends his days saying, with varying inflections and varying contexts, "no."

He says "yes" only a few times a year. His rule is that he reserves his yesses for organizations so wealthy that if he said "no," some other banker would quickly say "yes." His business might be defined as the lending of money exclusively to people who have no pressing need of it.

Or, in a slightly more serious tone, Phillip Zweig explains in his biography of former-Citigroup chairman Walter Wriston: "A banker's character should be contradictory; he must be a salesman who can say no."

6. The other most important thing is efficiencyI trust it's obvious that a more efficient bank is preferable to a less efficient one -- I'm referring here to the efficiency ratio, which is computed by dividing operating costs by net revenue. But what isn't as apparent is just how important this is.

A bank's objective is to maximize its return on equity. If this objective is hindered by low efficiency, then the slack must be made up elsewhere. And the easiest way to do so is to increase leverage and reduce credit standards -- which, as I've already intimated, is a recipe for disaster.

Discussing how inefficiency fueled the latest crisis, Columbia business school professor Charles Calomiris explained in Fragile By Design: The Political Origins of Banking Crises & Scarce Credit (emphasis added): "Given an environment in which risk-taking with borrowed money was considered normal, it is easy to understand why some bankers, particularly those who were having trouble competing against more efficient rivals, decided that the right strategy was to throw caution to the wind."

It accordingly makes sense that the banks which fared best in the latest crisis -- some even thrived because of it -- were also some of the most efficient. Three that come to mind immediately are Wells Fargo, US Bancorp, and M&T Bank.

Consider this anecdote from a recent profile of Wells Fargo CEO John Stumpf:

John Stumpf, a banker who earned almost $23 million last year, is cheerfully picking the stuffing out of a cracked leather armchair in his office. The chair, inherited from an even more frugal predecessor, is the most decayed of a worn set around Stumpf's conference table, a perfect set piece for his brand of subtle showmanship. He revels in his humble surroundings, proudly pointing out the "shabby" decor and rust-red carpet ("very '70s") of his yellow-lit executive suite.

Asked if Wells Fargo would ever upgrade its San Francisco headquarters or consolidate its scattered offices around the city into a gleaming flagship, something to rival Manhattan's spaceship-like Bank of America tower or its elegant new Goldman Sachs building, Stumpf scoffs: "That's not us."

7. Exceptional banks make exceptional investmentsGiven everything I've just said, this is perhaps an odd note to end on. But the fact that the bank industry is so fraught with peril makes it easy for exceptional banks to not only survive but to thrive through multiple cycles over long periods of time.

Consider the returns of the three banks just mentioned. Since 1990, US Bancorp has yielded a total return of 4,140%. Wells Fargo produced a return of 3,880%. And M&T Bank came in third at 3,010%. All three of these not only smashed the broader market, but they also outperformed their most notable shareholder: Warren Buffett's Berkshire Hathaway.

The point here is simple: If you want to invest in bank stocks, it's important to do your homework, buy the best, and then sit back and let the law of compounding returns do the rest.

John Maxfield has no position in any stocks mentioned. The Motley Fool recommends American International Group, Bank of America, and Wells Fargo. The Motley Fool owns shares of American International Group, Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo and has the following options: long January 2016 $30 calls on American International Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Such is why I avoid the super large banks. I like the smaller regional banks. On average they are much more prudent and grow earnings by expanding their customer base as well as their geographic footprint.

The mega-banks are thoroughly saturated and typically achieve earnings growth through product expansion as well as growth of their own investment portfolios.

A word of caution with regards to investing in banks. Take the balance sheet with a grain of salt. They are all heavily levered by their very nature; so the value of the company (as well as its capacity to put capital to work) is entirely dependent on its book value. A slight change in book value of the underlying investments on their balance sheet has devastating effects on the firm.

The most extreme of these are the MReits. While returns and dividends have been promising as of late; they do not produce a good, nor provide a service. They are money traders, it is akin to putting your money in a "black box" and hoping more is in there when you open it later. I haven't invested in any of the large banks since 2002.

I don't know the answer about failure rates in other countries, however, we do know that the United States is more prone to banking panics than most other countries -- and particularly most other developed countries.

Since the mid-1880s, for instance, Canada has had only two bona fide panics -- in 1837 and 1839. And if you just look at the last two and half decades (since 1990), the only countries that had more than the U.S. were Argentina and The Democratic Republic of Congo -- though, to be fair, there were 18 other countries which, like the United States, had two over this same period.

The question, then, is whether the frequency of panics here is a good thing or bad -- or, rather, a bit of both. For instance, perhaps it's a byproduct (bad) of our economic model which has pushed the U.S. economy to such extraordinary heights since WWII (good).

Hmm, its seems that international vs domestic data is a bit difficult to find. However, a quick overview of the big 4 (JPM, BAC, WFC, C) reveals a startling disparity.

WFC is the only one of those four which operates solely in the United States. So, judging based on recent performance would suggest that investing internationally is not as lucrative as it might seem.

That being said, there are other factors. WFC has historically been very conservative and does not as aggressively partake in the investment banking side of the business. This is especially true in the ultra-high risk areas: credit default swaps, auction rate securities, low grade CMO's etc. They are not even involved in FX as far as I know either.

I am convinced that without the TARP bailout, WFC would have bought all three other firms in 2008-2009; and Warren Buffett would officially rule the world.